Column by Richard Colombik

By turning the sale of your business over to a private annuity company, you can keep the IRS at bay. Here's how.

Your business has matured. Your baby has grown. Time to cash out and sell. Since you have held your shares for greater than one year, the gain qualifies for long-term capital gain taxation; a 15% Federal tax rate -- not bad!

Still, 15% of a $10 million gain is $1.5 million. With a $20 million gain it is $3 million. That's an awful lot of money. Paying $1.5 million of tax on a $10 million gain leaves you less money to invest. The investment return on $1.5 million at a municipal bond rate, now at about 4%, is $60,000 a year. Ten years of investment return, without compounding interest on $1.5 million, is $600,000. Do you really want to give away that much money?

Is there a way of selling your company without paying any taxes these days -- and not running afoul of the IRS?

Fortunately, there is. A well-established, IRS-approved technique that is in the Internal Revenue Code, case law, revenue rulings, and treasury regulations is available. It is a version of a conventional insurance product -- an annuity -- and it is normally done privately, not through a commercial firm. Hence, it is called a Private Annuity. Instead of directly selling your company for cash, you would trade it to a Private Annuity Company, who would sell it, and provide you with an annuity of equal value to the full selling price.

It is not as complicated as it seems, especially if you use experienced tax counsel. So let's break this down and see how it works.

First, let's address how a Private Annuity Company is formed before we discuss what an annuity is and how it will save you a lot of current income tax.

A private annuity is formed by having a contract between the provider of an annuity, The Private Annuity Company, and the person receiving the annuity, the Annuitant (note: the Annuitant is the party selling the business who does not want to pay tax.) The Private Annuity Company generally will be a newly formed entity, a limited partnership, a limited liability company or a corporation, usually owned by younger generation family members, but it may be owned by anyone, excluding the Annuitant. The Private Annuity Company will provide an annuity contract to the Annuitant, just as a commercial annuity company would provide an annuity contract to an annuitant. The Annuitant would transfer property to the Private Annuity Company in exchange for receiving an annuity. The annuity would have a value equal to the property received from the Annuitant. This is the same process that would occur through a commercial annuity company, except the annuitant would generally provide cash, versus stock in the company, to a commercial annuity company, which would in turn provide the Annuitant an annuity with a value equal to the cash received.

Now that we have created our Private Annuity Company, let's address what an annuity is and how it works. After all, isn’t this about saving tax?

Most people are familiar with an annuity as a type of product offered by life insurance companies. An annuity is a contract where you provide the annuity company a sum of money. The insurance company provides you a contract where they agree to make payments back to you over a period of time. You would decide when the payments would start and how long the payments to you would continue. You would also decide if the payments would be measured by your life span, or by the life another person, such as your spouse.

You would select a date to receive your first payment, called the annuity starting date. If the payments begin immediately, this type of annuity is called an immediate annuity. The payments, however, could began at any point in time you agree to, such as in five years, 10 years, next week, or next month.

Next, you would select how long the payments continue. If you want the payments to continue for your life, the type of time frame is referred to as a single life annuity. If you selected the measuring period for payments to be your life and your spouse’s life, this type of term is referred to as a joint life annuity. You could also select a specific time period, or a term certain, such as 10 years, 20 years or whatever term you desire.

All variables, including the starting date, the amount of time the annuity will be paid for, a specific term versus a life time, and a guaranteed return versus a variable term, will affect the amount of payments you receive.

Annuities are approved within IRC §72. It allows a person to transfer property to another and receive back a stream of payments. Each payment that you receive from the annuity company will contain two or sometimes three components. The components are:

Return of principal, (your cost basis)
Capital gain, (depending on the property transferred) and
Interest or investment income

So how does this device allow your stock sale to incur no immediate income tax?

What makes this work for tax savings are two factors:

1. The creation of an annuity usually is not a taxable event.
2. Every payment of the annuity has a fixed fractional component that consists of your taxable gain, a portion that is your return of capital, and a portion that is ordinary income.

Let’s apply this to a hypothetical sale of company stock.

You transfer $10,000,000 of stock, with a cost basis of $100,000 for a $10,000,000 annuity. At this point, you have a promise to have money paid to you, but you have not received any money. The company or party you transferred your shares to -- that is, the Private Annuity Company -- now owes you a $10,000,000 annuity. Therefore, the annuity company’s cost basis in your shares is $10,000,000, the amount they owe you.

The annuity company now sells your shares to the seller that you have previously negotiated with to buy your shares for $10,000,000. The annuity company, not you personally, sells the shares for $10,000,000. The annuity company has a $10,000,000 basis, or cost for the shares, which is the amount it owes you. The annuity company has no taxable gain, as it sold the stock for $10,000,000 -- the same amount it agreed to pay you for such shares.

As a result, you would have no taxable gain, because the annuity company has not yet paid you for the stock. Hence, the sale occurred and no tax has been paid. Meanwhile, $10,000,000 will be invested with the principal and earnings available to make annuity payments to you.

In a conventional annuity, you would make a transfer of cash to an insurance company in exchange for the insurance company’s promise to pay you back the funds, with earnings in the future. With a business sale, you would transfer your company shares to a Private Annuity Company, possibly owned or controlled by younger generation family members, in exchange for the annuity company’s promise to pay you back the funds with earnings in the future. The promise and annuity contract would be similar, whether the transfer is to a publicly held insurance company or a Private Annuity Company. Furthermore, with a Private Annuity Company and the proper structure, estate tax savings can occur as well.

A few words of caution:
1. The annuity must be properly written,
2. The interest rate, fair market value, must be per IRS tables,
3. The transfer of shares and control must be actually made, and
4. You cannot control the annuity company.

If you follow the appropriate steps, have the transaction drafted by a tax law firm familiar with how the structure operates, you can accomplish many goals, save tax to boot, and not have the IRS looking over your shoulder!